What iPhone's first-ever sales decline says about Apple's future

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Sales of Apple Inc.'s iPhone fell 16 per cent in the past year, the first such sales drop in the popular smartphone's nine-year history, as consumers replaced their devices less often.

In a fiscal second quarter that chief executive officer Tim Cook described as "challenging," Apple's iPhone sales slipped below 51.2 million units – down from 61.2 million the year before – but still above gloomier analyst expectations of 50 million devices sold. Revenue of $50.56-billion (U.S.) in the quarter was below analyst expectations, which had predicted it would fall as low as $52-billion, from $58-billion this time last year.

Profit hit $10.5-billion, down from $13.6-billion a year earlier, but earnings per share of $1.90 missed analyst estimates of $2.

While Apple saw its first quarterly decline in sales since 2003, downbeat expectations had been swirling for weeks. The stock has slid almost 20 per cent in the past 12 months and continued to fall in after-hours trading Tuesday.

"The lengthening of the product cycle – that is, how long people hold onto their phones – is going to continue to extend and that, in turn, impacts the overall smartphone market," said Bob O'Donnell, chief analyst at Technalysis Research.

Some analysts have speculated that, after years of product innovation and sales growth, Apple is finally about to "hit a wall," but sluggish sales in the middle section of so-called "S" years have become increasingly common for the company.

The Cupertino, Calif.-based company is essentially on a two-year product innovation cycle with its device portfolio leader, iPhone. Starting with the iPhone 4, Apple has delivered a fairly major device overhaul one year, which it then tweaks the next year and slaps an "S" on it (see iPhone 4s, 5s, 6s and so on). In the year after, the cycle begins anew.

"IPhone sales come from three sources: customers who upgrade, customers who switch, and first-time buyers," Mr. Cook said on a call with analysts. He confirmed that in the first half of year, the upgrade rate for customers buying the iPhone 6s and 6s Plus was slightly higher than the rate Apple saw during 2014's 5s cycle, but lower than the iPhone 6 and 6 Plus rate in 2015. Mr. Cook claimed very high Android switcher numbers, and suggested first-time iPhone buyers drove India's 56-per-cent sales growth.

The March introduction of the cheaper iPhone SE does nothing to disrupt that cycle – even though Mr. Cook said he was "thrilled" with the demand for the low-cost phone . Chief financial officer Luca Maestri said the SE drove down the average selling price for iPhones and contributed to the revenue miss.

All of which means analysts will continue to ask the question: What will Apple do if iPhone sales can't recover with the expected new device in the fall?

There is a school of thought that suggests tying Apple's value to the fortunes of the iPhone misses a key point about its ability to attract new customers to its product ecosystem. As analyst Horace Dediu recently wrote on his blog Asymco, Apple typically has been judged by the success or failure of its leading products: First the rise and fall of Mac computers, then the iPod moment drove its recovery and the iPhone pushed the company into the stratosphere. The rest of the tech industry has also suffered its booms and busts along the way.

"The industries Apple has been a part of are filled with one-hit wonders. Companies that had parabolic trajectories and built no loyalties. Statistically speaking, success in Apple's markets is always followed by failure," Mr. Dediu wrote in March on the occasion of Apple's 40th anniversary as he pondered its next 40 years.

"My simple proposal is to think of Apple (and actually any company) as a customer creator. It creates and maintains customers. The more it creates, the more it prospers. … This measure of performance for a company is not easy to obtain. It's not a line item in any financial report."

Those customers drove Apple's active device number past a billion machines earlier this year – an install base that is up 80 per cent from two years ago – and that has created a newly robust set of software and subscription services that Apple has built on top of its ecosystem.

Mr. Cook said he was pleased with the services group's performance, which hit its highest revenue in the company's history with $6-billion, up 20 per cent year over year. He went on to say App Store sales were up 30 per cent, Apple music has 13 million paying subscribers and Apple Pay is now adding a million new users a week. CFO Mr. Maestri also said the average amount spent per customer reached an all-time high in the quarter.

But that transition is still providing numbers well below what an Apple investor may find compelling. Denny Fish, a portfolio manager with Janus Capital, earlier on Tuesday gave CNBC a fairly concise summary of the bearish view: "We've moved from a penetration story worldwide in smartphones to a different narrative, and that narrative around Apple is what the business model looks like when it shifts to software and services ... we're just not entirely comfortable there yet."

Apple is also boosting the capital return program by $50-billion through a $35-billion increase in its share buyback authorization, under which the company plans to spend $250-billion by March, 2018.

With a file from Reuters